Through this article, we’ll discuss today the much debated mystery of inflation and will try to seek the possible solution.

Most of the debates revolve around the theory that there is a trade-off between growth and inflation. This theory has its roots in conventional economic ideologies.

On the other hand, now a days, there are people those are the proponent of the idea that there is no tradeoff between growth and inflation.

Let’s have a look on these thoughts one by one.

First we’ll delve into the thoughts of old school which says that there is a trade-off between growth and inflation. Here are some thoughts from the Executive Director, RBI, Mr. Deepak Mohanty:

The conventional view
India is a moderate inflation country. In the eight year period from 2000 to 2007, the world inflation averaged 3.9% per annum. Even the emerging and developing economies (EDEs) which traditionally had very high inflation showed an average annual inflation at 6.7%. India’s inflation performance was even better at 5.2 % as measured by WPI and 4.6% measured by the consumer price index (CPI-IW).

In 2008 the global financial crisis struck following which inflation rose sharply both in advanced countries and EDEs as commodity and oil prices rebounded ahead of a sharp “V” shaped recovery. Thereafter, inflation rate moderated both in advanced economies and EDEs. In India too the inflation rate rose from 4.7% in 2007-08 to 8.1% in 2008-09 and fell to 3.8% in 2009-10, however, it backed up and stayed in double digits during 2010-11 and 2011-12 before showing some moderation in 2012-13. Given India’s good track record of inflation management, the persistence of elevated inflation for over two years is apparently puzzling.

Deceleration of growth and emergence of a significant negative output gap has failed to contain inflation. It is understandable if inflation goes up in an environment of accelerating economic growth. There could be a situation when the real economy is growing above its potential growth that could trigger inflation what economists call an overheating situation.

During a boom, economic activity may for a time rise above this potential level and the output gap becomes positive. During economic slowdown, the economy drops below its potential level and the output gap is negative. Economic theory puts a lot of emphasis on understanding the relationship between output gap and inflation. A negative output gap implies a slack in the economy and hence a downward pressure on inflation. So, India’s current low growth-high inflation dynamics has been in contrast to this conventional economic theory. Real GDP growth has moderated significantly below its potential. Yet inflation did not cool off.

Reserve Bank raised its policy repo rate 13 times between March 2010 and October 2011 by a cumulative 375 basis points. The policy repo rate increased from a low of 4.75 % to 8.5 %. Still it did not help contain inflation. Interest rate is a blunt instrument. It first slows growth and then inflation. But the growth slowdown has not been commensurate with inflation control.

With the persistence of near double-digit inflation in 2010 and 2011, the medium to long-term inflation expectations in the economy have risen, underscoring the role of higher food prices in expectations formation. If inflation is expected to be persistently high, workers bargain for higher nominal wages to protect their real income. This creates a pressure on firms’ costs and they may in turn increase prices to maintain their profits.

Only in an environment of price stability, a step up in investment accompanied by productivity improvements could bolster potential growth. Even when the supply side factors dominate the inflationary pressures, given the risks of spillover into a wider inflationary process, there is need for policy response. While monetary policy action addresses the risk of unhinging of inflation expectations, attending to the structural supply constraints becomes important to ensure that these do not become a binding constraint in the long-run, making the task of inflation management more difficult. By ensuring a low and stable inflation, the Reserve Bank could best contribute to social welfare. (Excerpts from the speech delivered on January 31st 2013).

So, here is the fact that despite raising interest rates progressively RBI failed to put a check on inflation and moreover puzzled by intrigue behaviour of it being high contrary to the low growth rate. At last, Mr. Mohanty opined on the supply side constraints for it being the culprit behind current high inflation.

Now let’s have a look on the other side of the story and see the perspective of opponent of above-mentioned conventional theory, who says that there is no trade-off between growth and inflation. Here are the views of eminent economist Mr. Ajay Shah, Professor, National Institute for Public Finance and Policy:

The counter-view
All of us are aware of India’s inflation crisis. It is very disappointing, how we lost our grip on stable 4-5% inflation which was prevailing earlier. From February 2006 onwards, in every single month, the y-o-y CPI-IW inflation has exceeded the upper bound of 5%.

We also agree that there is something insidious when 10% inflation effectively steals 10% of the value of my wallet or fixed income investments. In India, however, we often hear the argument “Yes, this is bad, but if high inflation is the way to get to high GDP growth, let’s get on with it”. It is, then, important to ask: Why is low inflation valuable?

Nominal contracting is very important
Complex organisation of economic life involves myriad written and unwritten contracts involving households and firms. The vast majority of these contracts are written in nominal terms, i.e. in rupee values that are not adjusted for inflation.

Inflation is an acid that corrodes all nominal contracts. Two people may have agreed on a contract two years ago at Rs.100, but that contract is thrown out of whack because of 10% inflation per annum. That contract has to be renegotiated. Bigger values of inflation corrode personal relationships also, given that there are many financial ties within friends and family.

Inflation messes up information processing
Essence of a market economy is adjustments to relative prices, reflecting changes in tastes and technology. Firms learn about the viability of alternative investments by watching relative prices change. Inflation messes up this information processing. It increases the `background noise’ by making a large number of prices change at once. This makes it harder to discern which price change is fundamentally driven, and merits a response in terms of increased or decreased production.

Impact upon pre-existing nominal savings
For a person at age 60 who expects to live to age 85 or 95, fixed income investments are absolutely crucial in the financial planning of these 25-35 years. These calculations can be destroyed by a short bout of inflation.

Impact upon relationship with banks
When households expect inflation will be 12%, they will see a 4% interest rate paid by the bank as yielding -8%. This has many consequences. On one hand, households and firms expend excessive (wasteful) effort on minimising their holdings of low-yield cash. In addition, they tend to shift away from fixed income contracting with the formal financial system. Both these distortions are caused by inflation, and exacerbated by flaws in the financial system.

These may seem to be small things but they actually are fairly large effects.

But is there not a tradeoff between growth and inflation?
For a brief period, the empirical evidence in the US suggested that there was a tradeoff between inflation and unemployment. Here’s the classic picture, for the 1960s in the US:

Graph shows a nice relationship where higher inflation has gone with lower unemployment. This evidence has led many people, particularly those concerned with the plight of the unemployed, to advocate higher inflation.

A look at the same evidence for the US, over a longer time period, shows no such tradeoff:

The proposition that there is a trade-off between inflation and unemployment was pretty much dead by the late 1970s. One by one, as central banks moved to inflation targeting, aiming and delivering 2% inflation, unemployment went down, not up. Hawkish central banks are the central story about how the stagflation of the 1970s was broken.

There is no tradeoff between inflation and growth. High inflation damages growth and one element of India’s growth crisis is India’s inflation crisis.

It is important to think carefully about the accountability of the central bank. RBI is not in charge of India’s welfare. RBI is in charge of India’s fiat money. The one thing that RBI should be held accountable for is delivering low and stable inflation, i.e. for holding CPI-IW inflation within the 4-5% range.

So that we have seen both the perspectives, it is pretty much clear that high inflation is not a freebie rapped up only in the name of high growth rate. On the same note, the reason identified by Mr. Mohanty held its ground that supply side constraints are the key responsible factor behind this bout of high inflation.

And now, on the solution front, we can’t expect RBI to perform the duties of the Govt. and involve in the state affairs of distribution and supply of the resources. Government, rather than forcing and looking towards RBI to ease interest rates, should do their work sincerely.

All of us are aware of the wastage of the resources; be it rotten grains in the custody of FCI, unused frequency of bandwidth lying with BSNL and MTNL or for that matter line-loss percentage in power transmission. If they can only use these scarce resources effectively and devise a plan and implement the same to bring down the wastage gradually, our Finance Minister, Union of India, would need not to trade the path of growth alone, on the contrary RBI and entire nation would accompany him.

When India started trying to build a mature market economy in 1991, at first, it felt like a sophisticated financial system would emerge, which would both, serve India and start competing for the global market. From 1993 to 2001, India achieved a remarkable revolution in the equity market. This increased optimism in the ability of India to understand problems, to achieve change and to maintain high ethical standards.

It now seems that those hopes were premature. The revolution in the stock market used to be one of the best success stories of economic reforms in India. It might have fallen apart in recent month and years. The more likely scenario could be one where India-linked finance will happen offshore, while our regulators and government squabble over a minor and inconsequential onshore financial system that is riddled with ethics problems. In the short term, onshore Indian finance is suffering from one setback after another.

Business as usual, in India, is taking us to a destination where RBI, SEBI & company will preside over a minor and inconsequential financial system. The bulk of India-linked finance is taking place overseas, and the overseas market will dominate price formation for India-related financial products.

Why might this happen?

Money always follows the path of least resistance; therefore orders that used to come to India are easily being switched to other venues. An array of other venues has now come up:

• Nifty futures trade in Singapore on the SGX and in USA on the CME.
• An array of sophisticated derivatives on Nifty trade on the OTC market offshore (also termed `the PN market’).
• Derivatives on the rupee trade overseas on the exchange traded market and OTC market (linear contracts are termed `the NDF market’).
• Trading in individual stocks is taking place on the ADR and the GDR market.

Mistakes of domestic policy are giving a substantial shift in India-related finance to overseas locations. The two most important pillars of the Indian financial system are trading in the rupee and in the Nifty, and with both these, India is rapidly losing ground. If present policy mistakes continue, the role of the onshore market will continue to decline, for both the rupee and Nifty.

The plight of the Nifty

Let’s focus on Nifty – the most important financial product in India. The success and survival of the onshore securities markets is fundamentally about NSE. NSE faces an array of problems rooted in domestic policy whereas the overseas markets offering India-linked financial products are already developed financial centres and face no such problems. In the baseline scenario, Indian policy-making will meander on clueless and unconcerned and NSE will continue to lose ground.

Things are neither that much simple nor only stop here. First, NRIs pioneered sending order flow to overseas venues, and made them liquid. Next are Indian MNCs, who run global treasuries, who easily patronize the overseas venues. And then there are HNI residents, who can take $200,000 per year per person outside India. In addition, the richest 1% of India would systematically shift money out of the country through various means fair and foul.

With these kinds of possibilities, Singapore’s appeal goes beyond just the type of markets it offers. For one, India demands new investors deal with a thicket of documentation. While opening a foreign institutional investment account in most countries takes a few days, in India it is up to six weeks. So the start itself is a hurdle.

And then, there is taxation. We, as India, should not tax the activities of non-residents. For a global investor, sending orders to the Nifty futures on SGX is tax-efficient as Singapore follows a residence-based taxation system. Sending orders to India is inefficient today (owing to the STT and the stamp duty) and is apprehensive about tomorrow (if GAAR is used to abrogate the Mauritius treaty).

The bigger hurdle is India’s more severe taxation. Singapore does not tax capital gains and its tax on interest income allows for certain exemptions, such as foreign-sourced dividends. Whereas, India has a 15% short-term capital gains tax on listed securities. Most domestic debt instruments carry a 20% tax on income earned, which according to many market experts is the “biggest showstopper”.

The obvious choice

Put these factors together, and suddenly Nifty futures on SGX are a credible option. And this is exactly how things have worked out. In 2008, before these troubles had come together, SGX open interest was 59.78% of NSE. By 2012, where all these problems have come together, SGX open interest has come to 101.77% of NSE’s. It is astonishing to see that for the biggest Indian product – Nifty – an overseas exchange has got superior open interest.

Things changed when SEBI banned Participatory Notes (P-notes) in October 2007. SGX’s share in the total open interest (outstanding positions) in the Nifty futures product rose to around 50% from as low as 6% before the ban. A year later, the market regulator lifted the P-note ban, which led to a fall in SGX’s share to around 25%. But since then, SGX’s share has been rising steadily again. SGX now enjoys a 68% share in the total open interest on Nifty futures contracts.

And the recent blunder that added to the misery is the GAAR fiasco that resulted in exodus of foreign investors’ from the Indian regulatory boundaries. And while the government has softened its stand on GAAR considerably, foreign investors now seem increasingly concerned about the uncertainties of Indian policymaking.

The predicament of Rupee

The Indian rupee has grown rapidly to becoming the 16^th most traded currency in the world. From less than 0.2% of the world forex turnover in 1998, it has grown rapidly to constitute about 0.9% of the world forex turnover in April 2010. It is one of the biggest emerging market currencies with the Korean Won, Russian Ruble, Chinese Renminbi and the Mexican Peso being its close competitors.

Trading in the rupee is composed of the following elements of the market:

The rupee-dollar is the most important price of the Indian economy. The overall market for the rupee is roughly $70 billion a day out of which roughly one-third is spot, and the rest is derivatives. The offshore market today is as big as the onshore market, as roughly half of rupee trading takes place in India.

In its 2010 triennial central bank survey on foreign exchange and derivatives market activity, Bank for International Settlements (BIS) also pointed out that about half of the dollar-rupee market was overseas.

Though the RBI has done away with many capital controls, access to the currency market onshore still has some restrictions giving rise to offshore currency trading. Having said that, it must also be noted that most emerging market currencies are traded heavily in prominent currency trading centres such as Singapore, Hong Kong, the UK and the US. This is an inherent feature of currency trading. Of course, countries which have capital controls tend to push a larger proportion of trading offshore.

The development in the Rupee market

InterContinental Exchange Inc. and CME Group Inc., among the world’s largest futures exchanges, have launched rupee-dollar futures contracts in the month of Jan 2013. This clearly shows the growing importance of the rupee in the global currency market.

Needless to say, large electronic exchanges will do their best to both capture market share and increase the size of the market. And given their advantage over domestic competitors of access to foreign market participants, as well as freedom with product design, the share of offshore trading could continue to rise.

Rupee trading on other markets does not necessarily mean that trading in local markets is shrinking. Though it may be the case that the cake is enlarging, but our slice isn’t.

As India internationalizes, domestic customers of financial services, and the foreign order flow, will increasingly shift their business to providers abroad considering the problems in the local financial system. NRIs do not like to send orders to India given that India as yet lacks a residence-based taxation framework; they would rather send their orders to US (on ICE & CME), Dubai (on DGCX) or London.

The obvious implication

When foreign investors send an order to India, there is an entire chain of activity where revenues are generated. This includes brokerage companies, accountants, lawyers, hotels, aviation services, etc. When the same foreign investor sends this order to Singapore instead, this entire chain fuels the Singapore economy instead. And as global interest in Indian derivatives surges, it is Singapore, not Mumbai that is reaping the benefits.

The swing shows how deeply a tax gaffe last year damaged foreign investor sentiment and the cost to an economy that has seen growth tumble to around 5.5% following the sharpest slowdown in a decade. India is now paying the price for poorly written rules last year aimed at ensnaring tax evaders, ironically including those routing investments through Singapore, which instead sparked outcry among foreign investors and an outflow of funds.

What worries India is that Singapore markets are now attracting flows in other derivatives, creating not only a missed opportunity for India, but also the risk of a parallel overseas market offering arbitrage opportunities that distort domestic prices.

Last but not the least, prospects of Bombay, emerging as an international financial centre will subside. If we can’t even hang on to market share for Nifty or the rupee, where is the question of competing against overseas financial firms or markets on things that aren’t India-linked?

Some steps in the right direction

Since all taxes are distortionary and a basic principle of public finance is that we should have a low rate that is spread across a large tax base; our first priority should be to achieve a low rate, a wide base, and the minimal distortions. Reduced rates will always yield welfare gains. The Budget 2013-14 makes progress on two fronts (reducing STT from 1.7 to 1 basis point, and reducing distortions between equities and non-agricultural commodities).

One more announcement from the budget was in best of the spirits: FIIs are allowed to trade in currency futures. This will also give more liquidity and depth to currency futures and there are two reasons for expecting this, taxation of commodity futures and the entry of FII orders flow.

Future finance ministers will need to navigate the difficult landscape of gradually scaling down taxation of transactions while retaining low taxation of capital gains (which has unfortunately come to be seen as a linked issue in the Indian discourse). There is much more waiting to be done: integrating currencies and fixed income, bringing sense to options, and getting away from the very high rates on the equity spot market.

The budget is an annual statement of accounts. But within it lie stated and unstated intentions. The FM has been focused on balancing the need for spending more (eying the general election) and worrying about a possible downgrade from the international credit rating agencies. That was his balancing act: tight-rope walking.

Precursor

The FM confined the fiscal deficit to 5.2% in FY13 and as expected, this arithmetic achievement is in line with his topmost agenda of averting a country rating downgrade. This transient appeasement of rating agencies, however, is the result of substantial Plan expenditure cuts across ministries in the last few months, a by‐product of which is slower GDP growth in second half of FY13. No wonder, the Q3 FY13 GDP growth figure just released stands at a dismal 4.5%.

Whether justified or not, Union Budgets have always generated excitement in India and ahead of the 2014 general elections, Union Budget 2013-14 was one of the most anticipated budgets. Not just taxpayers, but analysts and economists were expecting a bonanza from the FM ahead of the general election. Excitement was more than usual as it was presented by a man with a reputation for big bang budgets. And thus people were keen to know how populist it could possibly be? Especially against the backdrop of stubbornly high inflation and bloated Govt. finances.

Pandora Box Opened Up

And when the verdict came out, our FM appeared to have played very safe. There certainly wasn’t any big bang announcements and only minor tweaking here and there. The Budget could be termed prudent as it has not turned out to be outright populist. But the threat of bigger demons, including the YoY unchecked expenditure upsurge, continues to thwart us.

Like always, customary concerns over double-edged sword of deficit were expressed followed by an apt customary resolution to put the same under check. The Fiscal deficit for the current year has been contained at 5.2% of GDP and for the year 2013-14 is estimated at 4.8%. By 2016-17 fiscal deficit is targeted to be brought down to 3%.

However, committing to fiscal prudence is one thing; and sticking to the target entirely another. Thus, questions have been raised about how exactly the FM and his team would manage to bring down the deficit to below 5% in the next fiscal? For, while the expenditure has been raised substantially, very little has been done by way of increasing revenues. And the budget failed to provide any answer to the question.

In what ways the government planned to earn the pennies?

When activity on the equity market was taxed, eyeballs and capital moved to commodities trading. Commodity futures trading has grown by 3.5 times after 2008, while equities activity has stagnated. For long, lobbying market stakeholders were divided in two different sections; one demanded the removal of STT and the other demanded the equivalent taxation of transactions in equity as well as commodity market.

1. The FM proposed to levy Commodities Transaction Tax (CTT), a tax levied on exchange-traded commodity derivatives in India, of 0.01% on all non-agri commodity trades such as gold, silver, non-ferrous metals and crude oil. However, agricultural commodities will be exempted from this tax.
2. Partly meeting the demands of a vast section of market participants, the FM reduced STT on equity futures from 0.017% to 0.01% and for mutual funds and exchange-traded funds (ETFs), the STT component has been cut from 0.25% to 0.001%. Finally, for the sale or purchase of Mutual Fund units or ETFs on the stock exchange platform, the levy has been reduced from 0.1% to 0.001% and will be borne only by the seller.

The dividend distribution tax (DDT), a tax levied by the Indian Government on companies according to the dividend paid to a company’s investors, has been raised from 12.5% to 25% (plus surcharge and cess) across the board for debt funds.

The FM has also decided to tap the ‘super rich’ category in the country to collect more taxes. This category, classified as those with taxable income above Rs. 10 mn, would be contributing more this year in order to fund the necessary expenditures. However, the relief for them is that the surcharge of 10% would be valid only for a year.

A Tax Deducted at Source (TDS) of 1% has been introduced for land deals of more than Rs. 50 Lakhs. This is however not applicable on agricultural land deals.

Import duty on set top boxes, raw silk and mobile phones has been increased. Excise duty on cigarettes, Sports Utility Vehicles (SUV) and marble has been increased. Service tax would be applicable on all AC restaurants at the rate of 12%.

While the Disinvestment target hinges on stock market sentiment, the high and mighty Rs. 400 bn expectation from Communication Services is likely to be way off‐target. On the direct tax front, Income tax and Wealth tax estimates appear reasonable but corporate taxation growth pegged at 16.9% appears a tad on the higher side, given the slackening GDP growth and subdued corporate earnings.

Talking of indirect tax, excise and customs duty figures look achievable, but service tax projections seem heavily overstated at 35.8% YoY growth. Last year, this level of growth was possible only through increase in rates (from 10% to 12%) and inclusion of most services in the net. The same growth in FY14 on a high FY13 base is a difficult proposition.

And where the government would distribute these pennies?

The interesting aspect in the Union Budget was the increase in overall expenditure. Despite the need to curb the growing fiscal deficit, the FM has increased the overall expenditure to Rs. 16.65 trillion in 2013-14 (higher by 11.7% YoY).

A large part of this expenditure would continue to be made towards populist measures like increasing allocation to the NREGS scheme, PMGSY scheme for rural development, increasing allocation for minorities and scheduled castes etc. it was estimated that under these schemes total spending would be Rs. 55,000 crore before the end of the current year and it was proposed to allocate Rs 80,194 crore in 2013-14, marking an increase of 46%. MGNREGS will get Rs. 33,000 crore.

It is also interesting to note that the non‐plan expenditure is most likely to balloon on account of underreported subsidies. The target of a 10.3% YoY fall in subsidies looks far‐fetched in a pre‐election year. The assumed drop in petroleum subsidy depends on wishful eventualities – crude oil price levels remain unchanged, INR doesn’t depreciate and gradual diesel prices deregulation continues.

Despite the imminent implementation of the food security bill, the government has budgeted for Rs. 100 bn increase in food subsidy. Furthermore, rise in diesel will inflate food costs, procurement will be higher in the election year and minimum support prices can go up as well.

What’s in the store for AAM AADMI?

All the expectations of some new measures to boost savings, especially in the context of channeling long-term savings into equity have come pretty much to naught. In times of falling savings rate, the need was a substantial increase to Section 80C. This would have also made gold relatively unattractive. Instead, the budget only offered an additional interest deduction up to Rs. 1 lac for those first‐time home loan takers up to Rs. 25 lacs, besides Rs. 2,000 tax credit to income brackets up to Rs. 5 lacs.

Under RGESS, one of the most anticipated topics of this season, it was announced that a first-time investor can now invest in mutual funds as well as listed shares for three successive years, from earlier one year. Also the income limit for RGESS investor has been raised from Rs. 10 lakh to Rs. 12 lakh.

To increase the reach of the mutual fund industry, the FM allowed mutual fund distributors to leverage the stock exchange network. Therefore, MF distributors can now get access to the MF segment of stock exchanges. Though MFs have been available on stock exchange platforms since December 2009, now it’s going to be easier for both investor and the MF distributor.

The one glimmer of something new in the budget was the promise of some kind of inflation-linked savings instrument. The FM said, “In consultation with RBI, I propose to introduce instruments that will protect savings from inflation, especially the savings of the poor and middle classes. These could be Inflation Indexed Bonds or Inflation Indexed National Security Certificates.”

• Globally, wherever inflation-linked bonds are issued, there are certain standard practices, but the key issue in India is which inflation rate is used. Since these new instruments are supposed to be specially targeted at low and medium-income savers, one could justifiably assume that consumer inflation would be the measure.
• ·         In recent months, there’s been a lot of noise about declining wholesale inflation and the pundits have generally opined that consumer inflation will inevitably follow. Unfortunately, there is little evidence of this happening yet. Real inflation suffered by low and medium-income savers is even higher than the stated consumer inflation and it will be a travesty if these new bonds will be linked to wholesale price inflation.

Concluding thoughts

The Budget was largely silent on measures to attract FDI and increase exports so as to curtail deficits. The measures to boost investments in capital markets too were non committal. Overall the Budget was a lackluster one. All eyes were on the FM in the hope that Budget measures would look at reducing the fiscal deficit. Though he has pegged the fiscal deficit at 4.8% of GDP this year, he has also increased the expenditures. However, ratings agencies have already stated that there is not much impact of this budget on the sovereign ratings.

Given the constraints of limited resources, the Budget promises to kick‐start the investment cycle but the key lies in execution, which is still suspect. All in all, we feel that the FM has made his arithmetic work in the Budget. Whether the economy responds or not, remains to be seen.

In the end, however, it turned out to be short on facts, leaving everyone confused as to how the FM will add up the giveaways while creating growth. A confused stock market, unable to add up the contradictory facts highlighted by the FM, did the best thing it could under the available circumstance – sell.